The Progressive Real Estate Partners team spends a lot of time helping our clients understand the current market conditions relative to leasing and selling retail real estate. One of the key questions these days is how the rising short and long-term interest rate environment might impact retail real estate.
Although most of the items outlined below will likely put some level of downward pressure on retail real estate, there are also definitely some positives that will result from rising interest rates that I include toward the end of this blog.
The following are our conclusions:
- Short Term Rate Increases Will Reduce Discretionary Income: All variable rate mortgages and a certain amount of credit card debt, home equity loans, auto loans, and student loans are tied to short term interest rates. As short-term interest rates go up, so do the debt payments for these loans. For many consumers, an increase in debt service results in less disposable income. That could mean fewer restaurant purchases, fewer visits for beauty related services, or less spending for entertainment. Interestingly (and this is purely anecdotal) as I have been asking people what would be the first thing that they would cut back if they had to save $200/month, the answer is overwhelmingly “streaming/subscription” services. That’s likely good news for retail.
- Decreased Residential Purchases Can Have a Large Spillover Affect: We all know that housing prices have skyrocketed over the past 2 years. Many could justify paying these higher prices because interest rates were so low that even with higher prices, the monthly payments were the same as before the increase in home prices. With rising interest rates, monthly payments have increased significantly, resulting in residential sales decreasing. According to the CA Association of Realtors, residential sales in California in May were down 15.2% from the previous year. When a home sells, this has a huge effect on the economy. Real estate brokers cash a commission, banks make loan fees, property inspectors and appraisers earn fees, and then most new homeowners spend a lot of money on home improvements and furnishings. For every home that does not sell, this economic activity is taken out of the economy. As a result, we would expect furniture stores, home accessory stores, flooring and paint stores to be impacted.
- Reduction in Home Equity Increases May Reduce Large Ticket Purchases: When your home increases $50,000 in value in one year, it makes it psychologically easier to buy a boat or recreational vehicle, install a pool, perform a kitchen renovation, and other costly items because it feels like your increase in equity is paying for it. I don’t know whether home prices will decrease, stay flat, or just increase less rapidly, but I feel confident in stating that we won’t see the large increases in value that we have seen over the past 2 years. As a result, retailers that depend upon these large ticket purchases may feel the pressure of higher interest rates.
- Cap Rates May Rise: A lot of people believe that rising interest rates will automatically cause cap rates to rise. But keep in mind that cap rates are a reflection of current AND future rent expectations. If you had your choice of paying a 6% cap rate for a property that would be worth the same 5 years from now or a 5% cap rate for a property that would double in value in the next 5 years, you would be much more likely to choose the latter. We are currently experiencing low vacancy with virtually no development in the pipeline. This could bode well for rent increases over the next few years.
But what about the fact that interest rates are higher and therefore cash on cash returns are lower. One of our recent observations is that we have never seen a higher level of cash buyers than the past couple of years. It seems very evident that based upon the Great Financial Crisis that occurred 15 years ago, there has been a huge increase in the number of debt free commercial properties. Individuals who are doing 1031 exchanges with all cash properties are unaffected by the rise in interest rates.It does appear that single tenant cap rates may be starting to rise as buyers are concerned about locking themselves into very long-term lease terms with modest rental increases. The concern is that inflation may erode the cash flow. We have actually seen a shift in the past 12 months to multi-tenant properties that have overall shorter lease terms with higher annual rental increases. This ebb & flow is what makes the market so interesting.
- Increased Uncertainty for Developers May Reduce New Development: Developers, especially merchant builders who sell the property when they are done with the development/re-development, are fighting two major issues. The first is the uncertainty over construction costs. The second is the question of exit cap rates. The past few years of lower cap rates have solved a lot of problems related to rising construction costs. But as we have spoken to developers and tenants that rely on developers, we are observing a lot of uncertainty. The difference for a developer between selling for 5% cap rate vs. a 6% cap rate is likely the difference whether they make money or don’t make money. As a result, we expect to see less development in the near term until a greater amount of stability enters the market. This bodes well for owners of existing product as it will create less supply of retail space in the market and ultimately might result in higher lease rates.
- Increased Debt Costs for SBA Owner/User Buyers: We have observed a significant increase in owner/user activity during the past 5 years. This is a reflection of the increased number of vacant single tenant buildings that resulted from tenants that signed leases back in the 2000’s or earlier that have elected not to continue leasing their premises. In July 2021, a small business owner could borrow up to 90% of the value of a property with a loan that amortized over 25 years (and was due in 25 years) for 2.81%. Today that rate is 5.18%. When rates were 2.81% the disparity between renting vs. buying was significant. With these higher interest rates, it might make operators more inclined to continue renting.
- Certain Retailers Will Be More Impacted by Borrowing Costs: It is more important than ever to understand the balance sheet of your corporate tenant. Many marginal tenants were able to borrow significantly in 2020 to increase their cash reserves to weather the downturn caused by the Pandemic. Much of this debt was variable rate debt or short-term debt (under 5 years). As a result many retailers are likely to face higher debt costs over the next few years which could impact their ability to expand or reinvest in their stores. Smart property owners will pay more attention to the financial statements of their tenants.
So for those of you who are thinking that this blog is a bit of a “Debbie Downer”, I don’t think this is the case. In fact, in my opinion, markets that are out of balance are not good for the overall economy OR the retail sector. I believe that steady, somewhat predicable, growth is what is best. Rising interest rates may cause some pain, but they should also get us back to:
- A world of lower inflation.
- A more predictable commercial real estate market where developers and retailers don’t have to fear their construction bids and proposed timelines.
- A more balanced employment sector so retailers can be motivated to expand because they know they will be able to find employees.
- An investment sales market where buyers and sellers can share similar outlooks and thus reduce pricing gaps.
- A residential market that “makes more sense” since all we have been hearing from so many is that the most recent residential market “makes no sense”. This “makes more sense” market would have steady increases in home values without major fluctuations giving homeowners more confidence in their purchasing decisions.
- An economy with less government financial intervention which would allow markets to function more efficiently.
These are confusing times and I welcome your feedback. If you want to discuss this blog or, if there is any other way I can assist you, please send me an email at firstname.lastname@example.org. On behalf of the entire Progressive Real Estate Partner’s team, we wish you continued financial success as we all navigate this changing economic environment.